Why Is It So Difficult to Value U.S. Bancorp?

We're in a tough spot as financial services companies, particularly banks, are getting hammered right now because of the sub-prime mess. When a stock gets hammered, the underlying company may become very attractive at the new price. Unfortunately, Morningstar doesn't give us the free cash flow data for these companies, so we have to dive into the annual reports.

First, An E-mail or Ten

A number of people have asked me how to do this via e-mail and I've sent virtually the same response which is something to this effect:

Many financial services companies are difficult to value because they have so many diverse revenue streams that are tied to the performance of the stock market, the bond market, and/or the housing market. When a business has to rely on sales, it can control its growth (or losses); but, when a business has to rely on sales and uncontrollable forces, it forces me to lose some confidence in my valuation.

Difficult Business: Merrill Lynch (MER)

Take a look at the Merrill Lynch Statement of Cash Flows on the SEC's EDGAR database. Some items that I have to wrap my head around are:

Undistributed earnings from equity investments (too shady to rely on � what is it exactly? Can they be lost?)

Other ($922 million of "other" cash � how can they show $922 million as "miscellaneous"? Shouldn't we know where that came from to know if we could rely on it?)

Trading assets (Like working capital, except it can be used or regenerated quickly. Problem is that we have to rely on Merrill Lynch's ability to trade; can they do it effectively considering that most people can't?)

Trading liabilities (Like trading assets)

Other, net (Again, miscellaneous cash. But $5.5 billion of uncategorized cash?)

What exactly is the cash that Merrill Lynch generates from its business of selling investments? If it had to stop trading and doing its other stuff, and focused solely on selling investments, what sort of cash would the business generate?

Now, I wouldn't bother with an investment in Merrill Lynch. Why? Specifically because I know the financial services sector and I know how difficult and "grey" its business can be. It is well within my sphere of competence and I know that Merrill Lynch has a million different ways to generate cash, pretty much all of which are directly tied to the performance of the stock markets. When the markets are running up, Merrill will generally do better. When they tank, Merrill Lynch will suffer. I don't like businesses that have to rely on such a volatile, uncontrollable variable.

U.S. Bancorp (USB)

To find the owner earnings of U.S. Bancorp, you have to go to the statement of cash flows and calculate it by hand. Here's the problem with Financial Services companies like banks: Capital Expenditures include more than just property, plants, and equipment.

How do banks make money? They earn interest on deposits and loans, take a cut for themselves, and give the rest to their depositors. To do that, banks must purchase and sell loans or they won't be able to pay the savings accounts and CDs, and as a result, they'll lose their business.

If you look at the 2006 Statement of Cash Flows for U.S. Bank, you'll notice two line items under "Investing Activities: "Proceeds from sales of loans and Purchases of loans. Without those "capital expenditures," our bank is probably going out of business, so we need to reduce owner earnings to reflect that.

U.S. Bancorp's Owner Earnings

To calculate U.S. Bancorp's 2006 owner earnings, we subtract the net loan expenditures and any property, plant, and equipment CapEx from the Net cash provided by operating activities.

As it turns out, U.S. Bancorp does not have any property, plant, or equipment capital expenditures in 2006, so our calculation is simple:

	2006
Net Cash From Operations	$ 5,429
Proceeds from sale of loans	616
Purchase of loans	-2,922
Property, plant, and equipment	0
Owner Earnings	$ 3,123

As always, we calculate that for the past ten years in order to get an idea of U.S. Bancorp's growth.

The Result

There is no real consistency in U.S. Bancorp's numbers, so I don't quite know if U.S. Bancorp has peaked or if it is poised to grow. Of course, the past is supposed to give us insight into the future - not predict it. We can make assumptions even if the past is volatile, but it is riskier.

In the banking business, there is little need for moat, but it helps. U.S. Bancorp has a competitive moat over its much smaller competitors, but has fierce competition at its size.

Despite all of this, U.S. Bancorp does has a value. Let's assume that U.S. Bancorp could increase owner earnings by 10% a year for ten years, and then slow to 3% for the next ten (no moat, fierce competition...lower expectations). Then, using a 15% discount rate, U.S. Bancorp's intrinsic value in 2007 is around $64 billion.

I don't know how confident and comfortable I am in my predictions and assessment, but I still need to check the market to see if I am getting such a massive discount that I can afford to gamble a bit.

Value Versus Market Cap

As it turns out, U.S. Bancorp is trading right around its intrinsic value of $64 billion, or $33 a share. This is the norm as price generally follows value, assuming we have the right value for U.S. Bancorp.

Check out this graph of U.S. Bancorp (PDF, 42kb) to see how price follows value in the long-term, although it can do anything in the short-term.

Would I Buy?

No way. Re-read this post and look at all the holes, and speculation in my assessment. What did I do? I guessed at a bunch of numbers (because there was no consistency), and ended up with a value without any real data or reasoning, which is not a good way to make money.

Remember: Investing doesn't have to be that hard. If you love the financial services sector, go for it. If you are looking for value and growth, stick with the easy, no-brainer companies, valuations, and investments.

Comments

[imjlshaw]

I calculated NPV or DPV for USB out the 20 years to be about $32Bil, so I'm wondering what you used for the final discounted value of USB to get $64 bil as the intrinsic value. Did you use 10x on it's present owner's earnings of $3.123 Bil or did you use some other multiplier on it discounted 20th year owner earnings? If so why 3.68 multiplier on $8.735 Bil or why 10x on current owner earnings?